How to Make the Tax System Fairer and Save Social Security

It’s time to expand the payroll tax to include health insurance plans offered by employers.

The U.S. faces two major fiscal problems. Fortunately, there is a simple solution to both that also improves the fairness of the tax system.

The first problem is the size of the overall budget deficit. It is large—2.6% of GDP or $450 billion this year—and will continue to get larger even if tax reform leads to substantially faster economic growth. This is particularly true if Congress increases the defense budget, as it should, to 4% of gross domestic product and if the revenue-raising border adjustment tax is not fully implemented. Large budget deficits reduce investment and growth and hinder a nation’s ability to respond to military and economic crises.

The second fiscal problem is that Social Security is in financial trouble. Current benefits for retirees already exceed the system’s payroll-tax receipts. Benefits are therefore payable under current law only by drawing on the so-called trust fund, an accounting record of previous Social Security surpluses. The Congressional Budget Office estimates that the trust fund’s balance is rapidly declining and will be exhausted by 2030. The amount Social Security pays out every year will then exceed what it takes in by more than $400 billion. The government will face the choice of cutting all individual benefits by about a third, raising the payroll tax by 50% (from 12% to 18%), or using $400 billion a year of income-tax revenue to supplement the payroll-tax funds.

Both of these problems can be solved by correcting an anomaly in the current tax system. Health insurance that employees receive from their employer is not currently subject to either the income tax or the payroll tax. Sixty percent of American employers collectively spend more than $1 trillion a year to provide such benefits. If these benefits were subject to the payroll tax like all other forms of employee compensation, the government would collect an extra $135 billion this year. That extra revenue would be automatically credited directly to the Social Security trust fund.

These extra payroll-tax receipts would reduce the overall budget deficit over the next decade by as much as $1.7 trillion and would add that much to the Social Security trust fund. By 2030 the trust fund balance would continue to grow to $2.7 trillion and the national debt would be $2.7 trillion smaller than it would otherwise be.

A flush trust fund would allow the Social Security program to be put on firmer financial footing, just as it was after the 1983 reform gradually raised the age for full retirement benefits from 65 to 67. Since 1983 the average life expectancy of Americans in their 60s has increased by three years, suggesting that the age for full benefits might be raised now from 67 to 70 for those who are currently younger than 50.

The combination of the payroll revenue achieved by the three year delay in retirement eligibility and the 13 years of extra GDP growth by 2030 would raise the payroll-tax revenue in 2030 by about $260 billion, or 1% of projected GDP, implying a reduction of that year’s budget deficit by the same amount.

Taxing employer payments for health insurance would create better incentive effects than increasing personal income-tax rates. Because the tax would be applied to existing benefits, it would not raise marginal rates and therefore would not reduce the incentive to work or to invest.

The direct effect of taxing employer payments for health insurance would be to make such benefits more expensive to employees, accelerating the trend toward policies with higher deductibles and copayments. That in turn would help limit the rise in spending on health care that pushes up national prices for hospital care and other health services.

Although no one likes to pay more in taxes, it is hard to deny that the existing system of giving large tax benefits to Americans who happen to get health coverage from their employers is unfair to those who pay tax on all of their compensation. Expanding the payroll tax would improve the fairness of the tax system while shrinking the overall budget deficit and strengthening Social Security. It should be part of the tax-reform legislation Congress enacts later this year.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.